diminishing returns

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Copyright 2006 – Biz/ed

Theory of Firms

Costs, Revenues and Objectives



Theory of Firms

• Profit:–Difference between Revenue

and Cost

Π = TR - TC



Theory of Firms

• Revenue = amount received from the sale of goods or services

TR = P x Q



Theory of Firms

• Total Cost is the sum of all costs – fixed, variable and semi-fixed

• Fixed Costs – do NOT depend on quantity produced- Rent, Rates, Insurance, etc.

• Variable Costs –vary directly with the amount produced – raw materials

• Semi–Fixed Costs - may vary with output but not directly – some types of labour, energy costs



Theory of Firms

• Factor Costs:• Labour – wages/salaries• Land – rent• Capital – interest• Enterprise - profit



Theory of Firms

• Average Cost = Total cost divided by the number of units produced

AC = TC/QAVC = TVC/QAFC = TFC/Q



Theory of Firms

• Marginal Cost• The cost of producing one extra or one

less unit of output

MC = TCn units – TCn-1 / Q• If TC of 100 units = £500 and TC

of producing 101 units is £505, MC = £5.00

• Important concept



Theory of Firms

• Short and Long run:• Short run – some factors fixed

and cannot be increased/reduced• Long Run – time taken to vary

all factors of production• Short and long run vary

in all industries:



Theory of Firms

• Railways – short run –’easy’ to increase labour, long lead times for new rolling stock – 5 years?

• Supermarkets – short run – can buy new shelving, hire staff, etc but opening of new stores takes several years

• Local Builder – short run buys new tools, hires assistant; long run – purchasing a new van – a couple of months?



Theory of Firms

• Diminishing Marginal Returns• Assumptions – some factors fixed

(e.g. capital and land)• Adding variable factor – (labour) • Total Product• Average Product – TP / Q variable

factor (Qv)• Marginal Product ΔTP/ΔQv



Theory of Firms

• Increasing the variable factor:• TP rises at first, slows then falls• AP rises at first then starts to fall• MP rises, then falls, cuts AP at

highest point of AP, cuts horizontal axis at point where TP starts to fall



Theory of Firms

Objectives of firms:• Profit maximisation • Profit satisficing• Long term survival• Share price maximisation• Revenue maximisation• Brand loyalty• Expansion and market dominance

diminishing returns

Technology